PRIMER: ESG

Author: Jimmie Franklin | Published: 29 Aug 2019

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What is ESG?

Environmental, social and governance (ESG) are the three key
factors used to measure the sustainability and ethical impact
of an investment in a company or product.

The environmental element considers how a company performs
in terms of its impact on the natural world. This includes
whether it makes investments in unsustainable areas such as
oil, or a company that has high plastic use.

Meanwhile, social principles consider how a business manages
its relationships with employees, suppliers, customers, and the
communities where it operates. Does it build affordable housing
for its employees? Does it make unethical choices, such as
doing business with a supplier notorious for using
sweatshops?

Last but not least, there is governance. This benchmark
considers a company’s leadership, executive pay,
audits, internal controls, and shareholder rights. Does this
company do enough to ensure women can get in to top positions?
Has it implemented a flexible working policy that allows all
employees to manage their time beyond a standard 9-5?

"ESG is a broad, global momentum shift that is moving
societies and economies into a more focused, inclusive view of
the world," says Michael Doran, partner at Baker McKenzie. "It
actively promotes and asserts environmental, sustainability,
governance and ethical standards."

Investor activism has been a major driver for
ESG’s heightened profile. This includes screening
out companies that fail to meet a baseline of standards on
values such as the environment.

In other areas, the aim is to exert positive influence by
engaging with companies and influencing them to use best
practise. A recent case included an investor coalition putting
pressure on banks to enhance their social responsibility
standards and ensure that they respect indigenous community
rights.

This was followed by the World Bank, which issued what many
commentators view as the blueprint for green bonds in 2008. It
led the way for the International Capital Markets
Association’s (ICMA)
launch of the Green Bond Principles (GBP).

The World Bank has since raised $13 billion from more than
150 green bonds, which have been distributed in 20 currencies
to institutional and retail investors worldwide.

Thus far, green bonds have had a monopoly in the market over
other ESG products.

"There is a greater recognition among companies and issuers
that climate change is happening," Doran says. "This
recognition exists on both the sell and buyside of bonds.
Issuers find it easier to get their heads around them."

One of the problems is that there aren’t any
codified global standards. Differing interpretations of what
green is are rife.

Of course, that isn’t to say that organisations
and supranational bodies haven’t been working to
introduce regimes that companies can adhere to in their drive
to be more considerate.

ICMA’s GBPs are some of the most widely used;
Climate Bonds Initiative (CBI) certification is also generally
expected. The GBPs are typically updated annually to align with
the development and growth of the green bond market.

To comply with the voluntary GBPs, bond issuers must select
a category, which can include pollution prevention (reduction
of air emissions, waste recycling and others).

Transparency is encouraged by ICMA in reporting standards.
Issuers are encouraged to make, and keep readily available,
up-to-date information on the use of proceeds. This is to be
renewed annually until full allocation, as well as ad hoc in
light of any potential material developments.

A primary concern among companies has always been
reputation. For example, the Deepwater Horizon oil spill in
2011 greatly damaged BP Oil’s stature and left the
company indelibly linked with what is estimated to be the
US’ largest environmental disaster.

In comparison, by engaging with ESG, companies can see their
relationships improve with customers and investors.

With the rise of teenage activist Greta Thunberg and
countries such as
Britain looking to ban single-use plastics as of next year,
it makes sense for financial players to enter the ESG market
now to ensure they don’t suffer from the future
regulatory environment.

For example, cosmetics company Lush has built its reputation
on a commitment to environmental causes and community projects.
It has divested from product chains where child labour is used
and sells products that see 100% of sales go towards grassroots
projects aimed at tackling human rights abuses and animal
protection, among other areas.

Financial markets have generally responded well to ESG
principles.
According to Axioma, companies with better ESG standards
typically outperform their benchmarks and record stronger
financial performances than their counterparts.

"Capital markets have responded well to the ESG momentum
shift," says Doran. He points out that markets have shown
adaptability and pragmatism, and acknowledged that ESG-related
bonds are a rapidly evolving product.

With total issuance increasing year-on-year, there is a
general understanding from all sides that there will be
financial repercussions ahead if movement does not happen
fast.

"Banks have also acknowledged that this is an area whose
time has come," continues Doran. There’s also the
simple recognition that there’s money to be made,
and that the promotion of ESG activities will ultimately help
banks and investors make more money.

Deutsche Bank has been one of those to make a thorough
commitment to ESG activities. Gerald Podobnik, global head of
capital solutions and sustainable financing, tells IFLR that
the bank has committed to not financing any new coal power
projects, and has agreed to reduce its thermal coal mining
portfolio by 20% by 2020.

In addition, sources at BBVA say that "the financial
industry is joining forces in the fight against climate change
through sustainable finance".

They also point to sustainable loans as a key tool, stating
that banks can play a decisive role when they act as
sustainable agents for these loans.

What is the outlook for ESG?

Once upon a time, the ESG momentum remained firmly in
Europe. However, now that’s changing.

"We have regions such as China, which has decided it is
going to green its economy, which will be a challenge.
It’s currently a pretty brown economy," says CBI
chief executive Sean Kidney. "It has a long way to go, but the
ambition is voluble."

"The paradigm shift is clear," he says, predicting that the
pace of change over the next 10 years is going to rapidly
surpass that of the last five. "We are in the early days, but
what we can expect is a huge expansion of focus and activity in
this space."

This will include more rapid commitments from countries to
the Paris Agreement, strengthening of regulations in the EU via
the EU Taxonomy Framework, and through the UN’s
2030 Sustainability Goals.

"There is still much work to be done to make this a
coherent, cohesive marketplace," says Doran. "There are
potential flaws that need to be amended but moves will be
undertaken fast to address this. We are still in the foothills
of the ESG mountain."